The End of History: Why the Fed Will Fail

In 1989 Francis Fukuyama made a bold prediction. The world would become increasing democratic and market-oriented. Other political models would gradually wither away. He called this “The End of History.” Here are a couple facts about his prediction:

1. It would be difficult to find any other prediction in the humanities or social sciences that has proved more accurate. There are many more democratic countries than in 1989, and policy has become much more market-oriented in most countries.

2. When intellectuals discuss his prediction today, 99% assume it failed to come true. Indeed most utter the phrase “the end of history” with undisguised contempt.

The juxtaposition of these two realities has made a deep impression on me. How can we explain why so many brilliant people have failed to acknowledge Fukuyama’s prescience? In some cases people were too lazy to even inquire as to exactly what the term ‘end of history’ meant. In other cases they were too mesmerized by what they saw on the evening news. After all, doesn’t it look like “history is being made tonight in Libya”? In fact, history is probably (knock on wood) ending in Libya. For the rest of my life it is unlikely that I’ll ever know the name of another Libyan leader. At least I hope not.

My theory is that it looks very much like history is not ending, if you rely on impressions, not facts. After all, the cable networks are increasing able to bring political strife into our living rooms, which would have been invisible in past years. I’m old enough to remember major strife in various parts of the world receiving zero coverage on TV. Massacres in Africa. The Cultural Revolution in China. Pol Pot. The 1982 massacres in Hama. The list could go on and on. The world seems increasing violent, even as it becomes increasing peaceful and democratic and market-oriented.

How does this relate to the Fed? Here are two facts about monetary policy.

1. Economic theory strongly suggests that NGDP falling 11% below trend in the last three years has severely depressed real output (regardless of what other factors might have also depressed output.)

2. Economic theory strongly suggests that the Fed could have prevented this sharp slowdown in NGDP growth. Interestingly, the Fed agrees.

The implication is that Fed errors of omission caused much of the Great Recession. Yet very few economists believe that. No matter how powerfully theory and empirical evidence point in one direction (the end of history, the Fed’s at fault) if it doesn’t SEEM THAT WAY, even very bright intellectuals will go with the gut, and then invent whatever theoretical rationales they need to make their prejudices plausible. Policy impotence. A Fed capable of unlimited money creation is somehow incapable of debasing the dollar. Structural problems. Even though unemployment didn’t rise significantly during the big housing crash of January 2006 to April 2008, gosh darn it that housing crash must be to blame for 9% unemployment, because it seems like it’s to blame.

Imagine the FOMC were composed of 12 Spock-like characters, brutal logicians devoid of any biases. Ruthless in their reasoning. Then they might have been able to devise an effective response. But FOMC members are not Vulcans; they are flesh and blood humans, subject to all the usual biases.

I’m not asking the Fed to do any more than it’s technically capable of doing. But alas, I am asking it to do more than it’s humanly capable of doing.

That’s why the Fed will fail. Oh, they might do something useful, make things somewhat better. But there is no chance that they will do what Spock would do.

Part 2. What is the minimum acceptable action?

I don’t want to end this post on such a downbeat note. Here’s Jim Hamilton:

I would suggest that the more important and achievable goal for the Fed should be to keep the long-run inflation rate from falling below 2%. The reason I say this is an important goal is that I believe the lesson from the U.S. in the 1930s and Japan in the 1990s is that exceptionally low or negative inflation rates can make economic problems like the ones we’re currently experiencing significantly worse. By announcing QE3, the Fed would be sending a clear signal that it’s not going to tolerate deflation, and I expect that would be the primary mechanism by which it could have an effect. Perhaps we’d see the effort framed as part of a broader strategy of price level targeting. . . .

And while I’m offering predictions, I might as well make it a triple. If events do take this turn and Bernanke does act again, he’ll be the subject of personal political attacks even more vicious than we’ve seen so far. But I expect the Fed chair to go ahead with the policy in those circumstances anyway, because he knows it’s the right thing to do. I could even imagine the Texas Governor delivering a rousing speech, praising in his appealing drawl those who have the courage to make a personal sacrifice for the larger good.

But I don’t expect the Governor to include in such a speech recognition of one person who deserves such praise.

So both Hamilton and Greg Mankiw have suggested a price level target with a 2% trend growth rate. These are both highly respected moderates who don’t shoot from the hip like I do. They both praise Bernanke. I see this as a real test for Bernanke and the FOMC. If the Fed won’t even do this little amount . . . Something that would not require tearing up the (implicit) 2% inflation target and replacing with another number. Something that would anchor the price level and remove any lingering fears of high inflation. A policy that could be defended even if the Fed didn’t give a damn about unemployment at all, if the Fed lacked a dual mandate. If they won’t even do that much, then the Fed will have abdicated all responsibility.

Even the Hamilton/Mankiw proposal would represent failure, relative to what the Fed would be expected to do if rates weren’t stuck at zero. But at least it would be something (unlike Operation Twist, which seems like nothing to me.)

PS. I think Hamilton got a little ahead of himself in the final sentence. I’d replace “deserves” with “would deserve.”

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.